How will a Europe wide financial transaction tax (FTT) affect the repo market?
The fear of multiple exposures to the proposed levy along the transaction chain have fueled concerns it may hit - and consequently severely limit - areas such as the repo market. Repurchase agrees have emerged as a vital tool for managing the increasingly onerous collateral requirements brought about by regulation such as the European market infrastructure regulation for the central clearing of OTC derivatives.
If repo transactions are hit by the FTT, experts predict the market will dry up, reducing options for buy-side firms to shore up collateral and contributing to a predicted global collateral shortfall. Some even claim the European repo market could shrink to just a third of its current size.
Another fear of the FTT's effects on the repo market surrounds a possible move among traders towards longer-term trades. It is thought that, with a tax on each transaction, the buy-side will look to extend their trade maturity to one year or more, to avoid excessive FTT-related trading costs. The European Commission believes central banks will step in to make up for any fall in the repo market, but opponents of the FTT say it is unlikely central banks will want to substitute for the money market, which would in turn hit market liquidity.
What are the wider implications of a loss of liquidity?
Although market participants have called for an FTT exemption covering repo transactions, no such proposal has been mooted by the 11 member states backing the tax or the European Commission. If the repo market was to collapse and liquidity became constrained, there would be severe knock-on effects for securities markets.
A further reduction in European trading volumes after a prolonged low volume environment would limit execution quality and potentially drive trading costs up further. Greater costs will be passed on to end-investors, leading to less money for the real economy.
Opponents of the FTT argue that it will inefficiently tax the economy, as the cost of raising €1 of tax will cost the economy more than €1 due to the costs associated with reduced volume and fragmented liquidity.
How might liquidity become fragmented?
The key fear among market participants is that there be a 'liquidity flight' following the introduction of the FTT. Those issuers outside of the FTT-zone, but within the European single market, will have a competitive advantage and many fear funds and asset managers will relocate and fragment liquidity across other markets.
However, supporters of the tax are not convinced by this argument, as the 11 countries looking to implement the FTT represent more than 60% of EU GDP. The tax was designed by the Commission to reduce the likelihood of liquidity shifting easily to other markets and is universal in nature - in its current form it will hit transactions involving a market participants based in one of the 11-member states, or any instrument issued within one of the member states, regardless of where in the world it is traded. For instance, a German asset manager will still be hit if trading a UK-issued stock on the London Stock Exchange.